Liquidating distribution from partnership
A cash distribution in partial redemption or liquidation of an owner’s equity in the business provides liquidity for the owner who wants to remove value from the business, may protect the liquidity needs of the business, and may avoid the tension that otherwise could arise among the owners in the absence of a buy-back program. However, the distribution of cash comes with a business and economic cost to the distributee-owner: their equity interest will have been reduced, they will likely be entitled to a smaller share of business profits, distributions, appreciation and sales proceeds, and they may have a smaller vote in decision-making. This “market” is accomplished by causing the entity to periodically offer to buy back a predetermined portion of its equity, usually subject to a value cap set by the entity’s managers that takes into account the reasonable needs and prospects of the business. By subscribing to our website, you expressly consent to your information being processed in the United States.Alternatively – and this is the way that most closely held businesses handle the issue – the entity will not have adopted a formal buy-back program; instead, its managers, acting on an basis, will decide, when the occasion arises, whether to buy back some of the equity proffered by an owner in need of cash.
The taxable income of a C corporation will be subject to federal tax at the corporate level at a flat rate of 21 percent.[xvii] The after-tax income of the corporation will not be taxed to its shareholders until it is distributed to them.[xviii] An S corporation is generally not subject to a corporate-level income tax.[xix] Rather, its taxable income flows through, and is taxed, to its shareholders[xx] at a maximum federal income tax rate of 37 percent, even though no part of such income has been distributed to the shareholders.[xxi] In order to allow the subsequent “tax-free” distribution from the S corporation to a shareholder of an amount of cash equal to the amount of corporate income that was already included in the gross income of the shareholder, the shareholder’s adjusted basis for their S corporation shares is increased by the amount of income so included.[xxii] As in the case of an S corporation, a partnership – including an LLC that is treated as a partnership for tax purposes – is not subject to federal income tax; its taxable income is reported by its partners on their tax returns, and they are taxed thereon without regard to whether any distribution has been made by the partnership.[xxiii] Also as in the case of the S corporation shareholder, a partner’s adjusted basis for their partnership interest is increased by the amount of partnership income that was included in the partner’s gross income, so as to allow the distribution of such an amount of cash to the partner without triggering additional recognition of income.[xxiv] Having reviewed how the owners of a closely held business may withdraw cash from their business entity after it has been taxed to the entity, or to the owners themselves, we now turn to the income tax consequences of a current distribution to the owners.
This owner may find themselves in somewhat of a bind, especially if they cannot compel a distribution, or if the entity is unwilling to make a loan to them. This Policy applies solely to the information collected in connection with your use of our Website and Services and does not apply to any practices conducted offline or in connection with any other websites.
What’s more, because an interest in a closely held business is, by definition, not readily marketable, this owner is unlikely to find someone outside the entity who would be willing to purchase some of their equity; in fact, it may be that the owners have agreed not to sell their equity to any outsider.[xvi] An effective way by which some businesses have addressed this issue is by “creating” a market for the owner who requires more liquidity than may be provided by a current distribution. [xxxvii] Of course, it is possible for a partner to have a split-holding period for their partnership interest, with some of the gain being treated as short-term capital gain. JD Supra's principal place of business is in the United States.
If, instead, the redemption is treated as a current distribution, then the amount of cash distributed will be applied against the shareholder’s adjusted basis for all of their shares in the corporation, not only those shares that were redeemed. With respect to both the shareholders of an S corporation and the partners of a partnership, the IRC Sec.
Only after the shareholder’s entire stock basis is exceeded will any remaining cash be treated as gain from the sale of a capital asset by the shareholder.
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In some cases, the manager of the business will be authorized to determine, in their discretion, if or when to make a distribution, and how much to distribute.[xiii] In other cases, the owners may have agreed that all “available cash” must be distributed at least annually.[xiv] Then there are those situations – in the case of a pass-through entity – where the only distribution required to be made for a taxable year is of an amount of cash sufficient to enable the owners to pay their income taxes attributable to their share of the entity’s profits.[xv] In each of these situations, however, every owner will generally receive a distribution based upon their relative equity in the business. We encourage you to read the legal notices posted on those sites, including their privacy policies.